The Energy Sector Is Starting To See The Light, But Will It Dim?

Rising oil prices fueled by new inventory data and geopolitical tensions have oil traders bullish. With oil prices hitting two-year highs, confidence is coming back to metros closely tied to the energy industry. The end of energy-related struggles may be in sight, but the road to get there is still long and winding.

“Pressure on oil prices [is] beginning to bubble up. There’s a cautious optimism,” JLL International Director Bruce Rutherford said.

Rutherford is head of JLL’s global energy practice, which recently put out a report on the outlook of energy-related commercial real estate markets. A record overhang of sublease space coupled with permanently changed capital expenditures and space requirements means despite the optimism, recovery for energy-related markets is still a long way off.

Houston, Denver, Calgary, Pittsburgh and DFW are all linked to the energy industry. All have experienced declining energy occupancy over the last year, the result of companies rightsizing and streamlining operations to reduce costs and shedding excess space to the sublease market. Even when the price of oil does fully rebound, capital expenditures will never be the same.

“Oil and gas companies are taking less space than they had before, everyone is becoming more efficient. That will stretch out the recovery and delay equilibrium,” Rutherford said.  

Oil's Recent Price Fluctuation

The price of oil must fully recover before struggling office markets do. Though oil hit a two-year high earlier this week, the price is still extremely volatile. Oil futures ended lower in volatile trading Wednesday after a weekly U.S. government report revealed a surprise rise in crude stockpiles but larger-than-expected declines in supplies of gasoline and distillates, sending a mixed message to traders. 

“A price of $62 a barrel will lead to increased capital expenditures, resulting in hiring and increased demand for real estate,” Rutherford said. 

On Thursday, Brent Crude was trading at $62 with WTI trailing behind at $56.

But realizing those gains in real estate will be difficult as competing forces make that price difficult to maintain. This week's total U.S. domestic crude production saw a climb of 67,000 barrels a day to 9.62 million barrels a day, EIA data showed. As a result, U.S. crude oil production hit an all-time high, a sign of the resilience of American shale drillers, making OPEC members wary. 

Tensions between American shale drillers and OPEC have been a defining factor for the price of oil. Adding to the volatility is geopolitical tension coming to a head in Saudi Arabia. This week Saudi Crown Prince Mohammed bin Salman moved to shore up his power base with the arrest of royals, ministers and investors, which an official described as part of Phase 1 of a crackdown. Making matters even more complicated, tensions escalated between OPEC members Saudi Arabia and Iran, which analysts said did more to rattle the market than the prince’s purge.

OPEC will meet at the end of the month to determine if the agreed upon production cuts boosting the price will be extended past March. With tensions flaring between OPEC members and American shale’s continued ascension, an extension of the agreement is anything but a done deal.

Oil's Effect On Office Space

According to the latest BLS and StatCan data, energy-related office employment reached an inflection point in 2017 with white-collar positions increasing despite the lower-priced environment. Despite this good news, nearly all markets expect energy tenant occupancy to remain flat over the next year. This is due to companies continuing to migrate toward smaller, more efficient office footprints and shadow space being backfilled.

In Houston's industrial sector, energy-related leasing activity is not a major demand-generator, comprising only 14.8% of transactions signed in 2017. Total volume and deal size have remained stable year-over-year.

“New office space demand will be tenant-favorable through 2018,” Rutherford said. “The correction will be slow, there’s a huge overhang of sublease space.”

Each city is dealing with an above-average sublease inventory, with Houston leading at roughly 9M SF. This massive inventory creates many options for tenants in the market and at a discounted rate to direct space, further extends the market correction.

Upstream's Pain Is Downstream's Gain

The upstream sector, focused on the exploration and drilling of crude oil and natural gas, has seen the most dramatic slowdown since 2014. Oilfield services companies have also been among the hardest hit by the downturn. Those companies have turned to cost-cutting, layoffs and consolidation, like Wood Group’s acquisition of Amec Foster Wheeler for $2.7B, or GE and Baker Hughes' $23B merger. The struggle can be seen in the millions of square feet of available direct and sublease space across Houston, the vast majority of it belonging to upstream companies. 

But some oilfield services companies are fighting back. New technology has lowered the break-even price, resulting in a year-over-year rise in rig counts. Rystad Energy reports companies like Weatherford, Nabors and Precision Drilling have increased their number of job postings in North America. Haliburton is adding 2,000 jobs as oil field activity picks up.

The downstream sector continues to shine. The emergence of American shale gas and oil has triggered a boom in domestic petrochemical production, the rising star of the energy industry. According to the American Chemistry Council, U.S. petrochemical investment sits at $185B as of October with 310 projects on the drawing board. The American chemical industry is expected to create 464,000 jobs by 2025.

The Texas Gulf Coast, where Chevron, Dow Chemical, Enterprise Product Partners and C3 Petrochemicals have invested billions, will be the biggest benefactor. These projects will provide an influx of resources and capital to neighboring areas in the form of development of manufacturing and storage facilities, helping the real estate market. Midstream companies will also benefit as additional pipeline and transport infrastructure will be needed. 

Oil's Effect On Small-Town America

Discussion of the energy market’s impact on commercial real estate typically focuses on major cities, but large cities are typically shielded from fluctuations in the energy market by virtue of their diversified economies. Small towns are not as lucky.

U.S. census data shows the majority of small towns losing more than 5% of their population post-boom were in top oil- and gas-producing states. Findings indicate the commercial real estate markets in small towns that grew in lockstep with the shale boom also suffered heavily as demand waned.

JLL Research surveyed real estate brokers in 150 small towns within the top dozen oil- and gas-producing states to ascertain the health of post-boom markets. The ratio of down markets to up is 3-to-1, with “falling” or “bottoming” towns representing 101 out of the 133 examined, JLL found. The national average shows that 76% of respondents indicate commercial markets are now “tenant favorable.” Market experts in the field often cite weak fundamentals and lots of available inventory in hard-hit towns.

These small towns will also be the slowest to recover. With oil and natural gas prices still low and technology consistently making the entire production and transportation endeavor more efficient, new employment growth on a net basis is unlikely in the near term. These towns can expect depressed employment numbers, little to no new investment and an increasingly transitory population to continue.

Oil's Speculative Future

For the oil and gas industry and the local economies tied to it, there is a sense of optimism growing. Traders are bullish, a factor that outweighs most others. Oil traders are sitting on a net long position of 502,900 WTI contracts, an eight-month high for that indicator, according to CFTC data. The net long position increased by a full 15% over the previous week's value.

A large speculative bet on oil futures has emerged — the price of oil is going up because traders want it to. But to maintain gains, Saudi Arabia must stand its ground with OPEC, U.S. producers must keeping shedding rigs and traders must keep bidding up prices for future contracts. For now, all eyes are on OPEC’s Nov. 30 meeting.

Whatever happens, American cities tied to the energy industry likely will not feel any serious effects for months as each deals with its own glut of sublease space and shrinking footprints.

Oil and gas remains a cyclical industry. After years of falling numbers, things are turning. 

“You can see it, we’re starting to feel this cycle turn,” Rutherford said. “We’re entering the right side of the [bathtub-shaped] recovery.”